The hybrid and other mismatch rules have applied since January 1st 2017. In this article, we reflect on the implications for M&A transactions so far.
Much of the initial focus when applying these rules has been on the term “hybrid”. Many groups are under the impression that the rules are only relevant to those who undertake tax planning using the most complex entities or instruments. However, their scope is actually much wider.
A useful approach has been to first identify circumstances where there is a mismatch in the tax treatment and then assess whether the rules apply.
The hybrid and other mismatch rules are aimed at two types of mismatch:
The points below are not intended to be exhaustive but set out some commercial situations where the rules could bite unexpectedly.
An example of the first type of mismatch is where an overseas group company has previously made a loan to a UK subsidiary, which is now being sold and where the debt is not fully recoverable and part of the loan is released. The release credit is typically recognised in equity and is not taxable. To the extent that the loan arose in a period beginning on or after January 1st 2016, the credit is not taxable on first principles, since nothing is recognised in profit or loss or within the statement of other comprehensive income. If the loan arose in an earlier period, there is a statutory exemption for releases of loans between connected companies.
Before the introduction of the hybrid and other mismatch rules, that would probably have been the end of the matter. However, we now need to determine whether the overseas lender obtains a tax deduction in relation to the loan release, resulting in a mismatch in the tax treatment. If so, the UK borrower may be required to recognise taxable income corresponding to the deduction.
Whilst the hybrid and other mismatch legislation does contain an exemption where the release credit is not taxable due to certain statutory reliefs, HMRC considers that this exemption does not apply where the release credit is not taxable on first principles (such as for loans entered into in a period beginning on or after January 1st 2016). As a result, the hybrid and other mismatch rules could apply to create a taxable profit for the UK borrower and it may be necessary to restructure the transaction.
This example illustrates how the rules can apply much more widely than expected.
One area of significant uncertainty is whether borrowing from a third party falls within the rules – and, practically, how the self-assessment of these rules should be approached.
The hybrid and other mismatch rules are relevant not only when there is a mismatch in relation to the borrowing entered into by a UK company, but also when there is a mismatch in the chain of funding which includes the loan to the UK borrower. HMRC draft guidance outlines the required level of linkage in the chain of funding, where it is reasonable to assume that the funds provided to the UK borrower became available as a result of another loan in that chain.
A borrower is unlikely to fully understand the chain of funding in a third party lender and the associated tax treatment, perhaps because the lender regards this as confidential. The borrower may not therefore know if there is a relevant mismatch. In order to test whether there is a disallowance, a UK borrower may aim to conclude that a third party lender is not a related party or in the same control group (referred to below as a related party).
There are some fundamental difficulties here.
It would be helpful if HMRC could provide guidance on how the tests of entitlement to income and assets on a winding up should come into practice.
Although uncommon, the rules also have to be considered where there is a mismatch in the recognition of taxable profits and losses, when dealing with transactions between UK resident companies.
Take the example where one UK group company borrows on floating rate terms, with another UK group company entering into an interest rate swap to fix the interest payments. In this instance, the two companies may enter into an intra-group swap which mirrors the terms of the external hedging contract to transfer the benefit and burden of that to the company undertaking the borrowing. In economic terms, each company is naturally hedged, but how is this intra-group contract to be taxed?
Even though all of the profits and losses from the contract will be taxed in each company, there is likely to be a mismatch in the exact timing of recognition of these taxable profits and losses. This raises questions as to whether this mismatch is within the scope of the rules and requires counteraction.
Depending on the particular circumstances, it may be concluded that there is not a mismatch which requires counteraction. But this is unlikely to be straightforward and further HMRC guidance would be helpful on how they see the rules applying in such a context.
These rules are relevant to all types of deductions, including payments for goods and services. Their potential application to all types of deductions will therefore need to be covered as part of the due diligence on a target group, as well as in structuring the acquisition.
Examples of situations where the hybrid and other mismatch rules can apply in unexpected circumstances are included in a series of articles here.
The combination of the hybrid and other mismatch rules with the corporate interest restriction and corporation tax loss reform means that a group’s tax profile post-acquisition may now be much more complex, both in terms of modelling and managing the use of tax attributes. Tax models will need to deal with the order in which the various rules apply and when carrying forward amounts which have been disallowed.
Our experience to date of the hybrid and other mismatch rules is that there are significant deficiencies in the legislation which means that it applies in unexpected circumstances and can produce inequitable results. Changes being made in Finance Bill 2018 will generally clarify and improve the workings of the rules but there is still much to do. We would suggest that the key reason for these deficiencies is that although there was a consultation on the draft legislation, the practical implications were insufficiently understood by business, advisers and HMRC so problems were not identified at that time. We believe that there is a case for reviewing and updating the rules. A good starting point would be the approach taken in the successful HMRC consultation on modernising the taxation of corporate debt and derivative contracts starting in June 2013, which involved working groups looking as particular aspects of the rules.
This is an updated version of an article first published on line on 23 November 2017
For more information please contact:
Rob Norris - Director at KPMG in the UK
Mark Eaton - Director at KPMG in the UK